John Nichol and Joseph Balestrino, managers of the Federated Capital Income Fund, outpaced the Standard & Poor's 500 Index for the first...

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John Nichol and Joseph Balestrino, managers of the Federated Capital Income Fund, outpaced the Standard & Poor’s 500 Index for the first time in five years by investing in bonds and European telephone companies.

Nichol purchased shares of Hungary’s Magyar Telekom, Eastern Europe’s No. 2 phone company, and TDC, Denmark’s biggest phone company, for their high dividends.

Balestrino is focused on buying top-rated corporate bonds.

The fund, formerly known as the Federated Utility Fund, was battered in 2001 and 2002 by the collapse of energy-trading company Enron and long-distance phone company WorldCom.

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Since then, the fund has changed its name and taken a new investment approach by eliminating restrictions that it focus only on gas, electric and telephone utilities. About 62 percent of the fund’s $505 million was in fixed-income securities on Sept. 30, and the rest was in stocks.

“It’s a completely different fund,” said Arijit Dutta, an analyst at Chicago-based Morningstar, an industry research firm. “The bond side is what’s made a big difference.”

The Federated fund climbed 3.8 percent since the start of the year and through Nov. 16, exceeding the 3.3 percent advance of the S&P 500, including reinvested dividends.

It rose at an average annual rate of 13.9 percent in the past three years, beating the 12.8 percent gain of the benchmark index and the returns of about 85 percent of competing U.S. “balanced” mutual funds tracked by Bloomberg.

Balestrino made money for investors this year from his bet that yields on 10-year Treasuries would rise more slowly than the Federal Reserve’s benchmark lending rate. Since June 30, 2004, the yield on 10-year Treasuries has slipped 0.1 of a percentage point, compared with the 3 percentage-point increase in the Fed’s overnight bank lending rate.

Balestrino started to unwind the trade last quarter before 10-year Treasury yields rose to a 16-month high.

He said he is shifting the fund’s corporate-bond holdings to safeguard against shrinking corporate profit margins because of higher energy costs. About 24 percent of the fund’s bond holdings were in “AAA” securities as of Sept. 30, up from 9 percent on Nov. 30, 2004. Bonds rated “BB,” one notch under investment grade, are 27 percent of bond investments, down from 45 percent.

“Our expectations for earnings growth aren’t as positive as the rest of investors,” Balestrino said. “Margin pressures will show themselves in the fourth quarter or the first quarter [next year] because of rising costs.”

Nichol scouts for companies that pay large dividends relative to their stock price and then determines whether their balance sheets and prospects for earnings growth suggest payouts may increase. He has devoted 12 percent of the fund’s equity assets to telephone companies, four times their weighting in the S&P 500.

The dividend yield of the S&P 500 Telecommunications Services Index is 4 percent, making it the highest-yielding industry group in the S&P 500. The S&P 500 Utilities Index is the second-highest, yielding 3.5 percent.

Nichol holds 192,000 U.S. depositary receipts of Magyar Telekom in Budapest, according to the fund’s reports. The company, majority owned by Deutsche Telekom, has a dividend yield of 7.4 percent, higher than all but two companies on the S&P 500.